​​​Can companies create their own growth in Europe?

14/09/2016

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Late summer can be a tricky time to make market predictions. Behind us we have the result of the UK referendum, months of negative interest rates in most of Europe and a string of lacklustre economic data. Neatly summing up the distractions of recent weeks, the UK’s Financial Times conveniently pointed out that Great Britain won more medals in cycling at the Rio Olympics than it has trade negotiators able to work on “Brexit”. The latter are going to be more important to many than the former over the next few years, with the greatest respect and admiration for the athletes.

Politics is likely to ensure that uncertainty persists in the weeks and months ahead, which is a shame in my view. Still to come this year is the US election, the prospect of tighter monetary policy in the US and possibly more monetary easing from the European Central Bank. By year end we will also know the outcome of the Italian referendum on electoral reform, and will be beginning to try to figure out what might come from the national elections in France and Germany in 2017.

Is growth evolving?

As for what is happening among companies, news has been in line with fairly subdued expectations. The key here is that expectations have been low as growth remains low. Given that most companies are generating cash, investing some in expansion and development and returning a portion to shareholders, there seems to be a kind of ‘quiet equilibrium’ in progress – where governments are failing, companies are picking up the slack. Spain’s Amadeus, for example, involved in airline ticketing and IT systems, is expanding into hotel booking systems to enable hotels to manage their capacity, pricing and general costs more effectively. It has continued to expand with existing customers as well as win new ones. So despite last year’s scare, where German airline Lufthansa attempted to encourage individuals to circumvent travel agents and book direct by adding a fee for using middle men, Amadeus nevertheless continued to grow well in the first half of 2016. Incidentally, Lufthansa, in common with other airlines, has been finding life quite tough in a deflationary world with excess capacity.

The M&A route to expansion

We are also seeing more corporate (merger and acquisition) activity in Europe. Very shortly after the UK referendum, one of the UK’s finest technology and growth companies, ARM, accepted a bid from Softbank of Japan. The 40% premium pushed the company’s share price to where reasonable estimates suggested it may have reached anyway by 2019, although on the negative side, little now stands in the way of another great UK company disappearing. Elsewhere, Bayer is trying to buy US agricultural produce producer Monsanto, and Linde, a German firm involved in industrial gases, has confirmed talks with US rival Praxair about a merger. In a low growth world with ultra-low interest rates, more such deals look likely.

The interest rate conundrum

There remains a growing tension between the support from lower interest rates and negative bond yields and ever-higher valuation levels for equities, in spite of the modest growth outlook. There may well be an adjustment – especially if signs of inflation do finally emerge. In the UK, for example, it seems likely in my view that inflationary pressures will pick up from here, possibly reaching above 3% over the next 12 months, given the devaluation of sterling. Whether the Bank of England can maintain such low interest rates, having just reduced them to another record low on concerns about a sharp post-Brexit slowdown, remains to be seen. It could therefore be a more difficult autumn for markets in the light of these contradictions and greater uncertainty.

In this environment it seems to me that quality at a reasonable price is arguably the correct area to be. Having added a small amount to a more cyclical quality name, UK industrial equipment supplier Atlas Copco, at the end of last year, we are detecting more discussion about the possibility of some more fiscal easing in Europe, which we believe should boost demand for equipment again. This has proved supportive already. More broadly, equities remain well supported by dividend yields and steady, albeit modest, growth.

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